The easy money created by the Federal Reserve via QE has long since been the root cause of asset price distortion well beyond what fundamentals dictate. Some in 2014 theorized that the liquidity injected into the economy has not only boosted equity prices to record levels, (17 P/E ratio 90% quartile for S&P for example) when GDP is near zero for 1Q15, resulting in the slowest and lowest job recovery in the US, but also because open interest in oil futures far exceed 2008/2009 levels.
This latter point has some merit as, at the peak in 2014, open long interest was multiple times vs. the prior peak before the financial crisis. Oil has crashed over 50% twice in the past 6 years which is unique in recent history and which may well be another symptom of Fed money printing. Well that money or liquidity hasn’t gone away but has manifested itself in other areas of the economy such as a bubble in Biotechnology and now in the billions of private equity raised in past 6 months to invest in energy. Related: EIA Changes Tack On Latest Oil Crisis
The US equity market rise is growing long in the tooth, as mounting evidence surfaces that the US economy isn’t as strong as the media professes and that many of the indicators (such as U6 unemployment at 11% vs. 5.4% headline number…the former accounts for those dropped out of workforce) are showing some real weakness. Thus the money has to go somewhere and it’s continuing to distort asset prices for sure and, since the E&P equity prices have crashed back to pre-crisis levels, it’s finding a place there as opposed to the broader market. Related: Oil Rebound May Come Sooner Than Expected
Conversations with E&P executives reveal that the bid/ask spreads have widened for asset sales in part because the EV/EBITDA multiples have risen in the E&P space when commodity prices have crashed. Running comparables for E&P companies on 2015 multiples reveals that lower quality, more highly levered E&P companies trade at 5-6X while higher quality companies trade at 10-14X much higher than historical norms. Related: How Much Longer Can OPEC Hold Out?
This distortion has even slowed the M&A market dramatically too, as bidders look to buy at current strip while sellers hold out for better pricing in 2016. This in part because 2015 EBITDA is depressed and it’s anticipated rightly or wrongly that prices will recover. But it’s also tied to private equity monies chasing yields adding to the bidding process for assets. The fear is that this will slow the healing process in clearing the market of poorer run companies and lower quality assets which have no business existing in the current strip environment. After all, most public companies are still outspending their cash flow rending their free cash flow after capital spending negative despite being six months into this down cycle.
In the 2H15 what is likely to occur as WTI remains in the $50s is that the mature assets will likely be sold as many E&P companies deal with the reality that prices will be slow to recover above $70 at least in 2015. So expect the bid/ask on assets to narrow in 2H15 and M&A activity to increase. After all unless E&P deleverages, the healing process will be slow if anything and industry executives over the coming month will come to realize it. When this finally occurs, which should be in 2H15, it will likely signal that the energy space is on the mend and de risking is the norm, giving the investment community better visibility on allocating cash to the sector.
By Leonard Brecken for Oilprice.com
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